Debt demystified - Part 2

In Part 1 we looked at a debt-measuring tool known as the net debt-to-equity ratio. This figure gives analysts a tool to measure the amount of debt compared to shareholders' equity. It's useful for measuring the size of a company's debt but it doesn't tell you about the ability of a company to service that debt. After all, when making a new home loan, a banker isn't just interested in the property that a borrower puts up as security; they also want to know how well the customer can service the debt from their income. Similarly, analysts assessing the safety of a company should consider how easily its profits and cash flow cover its interest payments.

Interest cover ratio

This is where the interest cover ratio comes in. It's calculated by referring to the cash flow statement in a company's annual report. In keeping with our practical example from last issue, we'll take a look at Sydney Aquarium . Page 20 of its 2003 annual report shows the company's cash flow statement, detailing the cash flowing into and out of the company's coffers over the year to 30 June 2003.

The most important aspect of cash flow, at least concerning debt, is the top third of the page titled 'Cash flows from operating activities'. After deducting operating expenses like wages, interest and corporate tax from gate takings, the group is left with a net operating cash inflow of $7,396,000. But this is already after the group has paid its interest costs of $703,000. We add the two figures together to work out operating cash flow before interest costs of $8,099,000.

We then divide this amount by the interest costs of $703,000 to arrive at the interest cover ratio. In this case it's 11.5, but what does this mean? That Sydney Aquarium's net operating cash flow 'covers' its interest bill 11.5 times, which gives it plenty of protection in times of adversity. To put that into perspective, its operating cash flow could drop by 90% from around $8m to just $800,000 and it should still be able to service its debt. And given Sydney Aquarium's steady business, that's an unlikely scenario.

All things being equal, the higher the interest cover the better. As this example shows, a company with an interest cover of 10 times could sustain a 90% fall in operating cash flow and still cover its interest obligations. But a company with interest cover of 1.5 times could be in trouble if operating cash flow fell by just 33%. You should also bear in mind that operating cash flow can be reasonably stable in some businesses and highly variable in others. So it pays to look at the interest cover over several years. While an interest cover of only two times may be safe for a company with rock-solid earnings like Woolworths or Tab, the same figure for a cyclical earner like Seven Network or Skilled Engineering should be cause for concern.

But care needs to be taken when calculating this ratio as companies sometimes report the interest costs further down the page in the 'Cash flows from financing activities' section. This means that the operating cash flow figure is already given before interest, so the interest bill doesn't need to be added back to it.

The interest coverage ratio can also be calculated using the income statement (formerly the statement of financial performance). This will give a profit interest cover ratio rather than cash flow interest cover. While we tend to place greater weight on the cash flow figure, it pays to calculate both as differences between the two can highlight accounting irregularities.

The profit interest cover ratio for Sydney Aquarium can be found on page 18 of its latest annual report. To the net profit of $6,006,000 we add the borrowing costs expense of $660,000. That net profit before interest costs of $6,666,000 is then divided by the borrowing costs of $660,000 to give an interest cover ratio of 10.1. The fact that this result is quite similar to the cashflow interest coverage of 11.5 provides further comfort that Sydney Aquarium can easily cover its interest bill.

In conjunction with the net debt-to-equity ratio, the interest cover ratio helps paint a picture of the size and affordability of a company's debt. Unlike the net debt-to-equity ratio, which is a snapshot of the financial position at the balance sheet date, the interest cover ratio takes account of cash flows throughout the accounting year and is therefore not prone to the effects of seasonality.

Adjustments

But that doesn't mean the figures can be considered in isolation. The numbers can be distorted by one-off events and, like all historical measurements, the interest cover ratio isn't a forecast of future debt-paying capacity. Looking again at Sydney Aquarium, at the start of the 2003 financial year it had $6.3m of debt versus $9.4m by year-end. So the monthly interest bill grew over the course of the year and, with a higher debt burden expected this year, the interest cover for the 2004 financial year is likely to be lower. Any acquisitions, and it seems Sydney Aquarium's management is keen to acquire something, would probably push interest coverage down even further.

While these ratios aren't the only aspects to consider when looking at a company's debt, they are important tools nonetheless. And they are essential calculations if investors hope to avoid the next One.Tel, HIH or Harris Scarfe.

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